When then opposition leader
Kevin Rudd
was campaigning for the prime ministership at the 2007 election, he made headlines nationwide and tripped up the Howard government by declaring: “This sort of reckless spending must stop."

Everyone heard what he said, loud and clear. But fast forward 5½ years and it seems no one really listened. As a result, Australia is facing a serious long-term budget problem that few in the Canberra political class seem, or want, to comprehend.

The Grattan Institute sounded an alarm bell during the week. It warned that Australian federal and state governments were ­staring at a “decade of deficits" topping $60 billion or 4 per cent of GDP annually unless there was significant spending cuts, including to politically sensitive areas of welfare, health and education.

Yet heading into his sixth and almost certainly final budget on the eve of the September 14 election, Treasurer
Wayne Swan
has declared he won’t be slashing spending because the government wants to protect the economy and jobs. “Particularly their own," a former government adviser muses.

Labor is promising new multibillion-dollar programs such as the Gonski education reforms and national disability insurance scheme, the latter of which most agree is highly worthy providing it can be funded.

But given the true state of the budget, including the build up of huge spending commitments beyond the four-year forward estimates, can Australia really afford to go down this path?

Debt due to overspend

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Europe and the United States are prime examples of what can go wrong when ­governments defer difficult decisions on spending. Instead of saving in the good times, they are being forced to cut spending at exactly the wrong time, when the economy is very weak.

Australian government net debt of around 10 per cent of GDP remains low by international standards, so it is no immediate cause for concern. But net debt has grown from negative $44 billion in 2007 towards $200 billion. While Australia is far from the basket case that is Europe, it is worth remembering that a rapid build up in debt was what hurt most European economies. Spain, Ireland and Iceland were thought to be in sound fiscal and debt positions before they blew up.

Swan has cast a sombre picture of the budget in the years since the global financial crisis, with constant reminders it has suffered from a “sledgehammer" hit to revenue and that tax receipts have “fallen off a cliff".

It has given the distinct impression that the government’s revenue has declined. If that were the case, that would be a real cause for alarm. The reality is that federal government revenue is increasing but has fallen short of over-optimistic forecasts predicated on an unprecedented bounce back in company tax revenue after the GFC.

Revenue in the past financial year grew a robust 9 per cent to $329 billion, short of the heroic 12.7 per cent originally forecast in the 2011-12 budget.

Stephen Bartos of ACIL Allen Consulting, and a former Department of Finance deputy secretary, says the claim that revenue is falling is inaccurate. “Revenue is still growing, it’s just not growing fast enough to meet the rise in spending," Bartos says. “A lot of that rise . . . is driven by health and ageing costs."

Spending rose 7.2 per cent in nominal terms to $371 billion last year, or from 24.7 per cent of GDP to 25.3 per cent. Total spending rose $118 billion or 46 per cent over the past five years, including the GFC stimulus.

Bureacracy gets bigger

Underlining how government keeps growing, the number of ongoing commonwealth public servants has increased by 10,437 to 154,307, according to the Australian Public Service Commission. That was after Rudd promised to take a “meat axe" to the public service.

In the last five years of the Howard government, spending rose at a similar runaway rate of 34 per cent and the number of bureaucrats surged 31,537 in the same period.

Much of the growth has been in more expensive senior executives, including in health and education, even though the Commonwealth doesn’t operate schools, universities or hospitals.

Still, there is some truth to the government’s talk about revenue being under pressure.

The Australian dollar has remained above parity for a couple of years, crunching the non-mining economy and hitting profits. The first part of the mining boom under Howard didn’t face a similarly high exchange rate when the terms of trade rose.

As a percentage of GDP, revenue is tracking at about 23 per cent over the past five years, down from an average, near historic high of 25 per cent during the Howard government’s reign from 1996-2007.

But that era was an unsustainable revenue bubble, off the back of the windfall gains delivered by the China-induced mining boom that took off around 2004. Macro­economics estimates that the commodity-boom, windfall revenues contributed about $160 billion to the commonwealth budget bottom line over the eight years to 2011-12.

Much of this extra revenue was doled out on personal income tax cuts, family ­payments and other middle class welfare, industry assistance and tax breaks for superannuation. “The Howard government engaged in a major discretionary loosening of fiscal policy over its last five budgets," Anthony says. “Even allowing for a one-off stimulus in the face of the global financial crisis, the Rudd-Gillard governments have also tended to outspend savings efforts, while continuing to raise expectations for future spending.

“As a result, the risk is that Australia’s medium-term structural budget deficit could deteriorate further based on new spending priorities and longer term spending pressures."

The structural budget balance, which strips out the effects of the temporary ups and downs in the economic cycle, is estimated to be in deficit to the tune of $41 billion or 2.7 per cent of GDP in 2012-13.

Notwithstanding challenges from the high Australian dollar to some industries, this is occurring when unemployment is relatively low at 5.6 per cent, the economy is growing about trend and commodity prices have been well above their long-term average.

In a further worrying sign, the budget is projected to remain in structural deficit for more than a decade, even if the government manages to restrain spending, says Anthony’s paper, sponsored by the Minerals Council of Australia. It notes the views expressed are his own. He was been making similar warnings for several years, since leaving public service confines.

Long-term outlook looks gloomy

Interestingly, Labor published similar structural deficit figures in the 2009 budget to finger the Howard government for its lax fiscal discipline during its final two terms.

The budget entered structural deficit around 2006-07 under Howard and treasurer
Peter Costello
, even though they were running headline cash surpluses of almost $20 billion. Labor has done little to address the structural deficit, and the government has mysteriously stopped publishing it in the budget papers.

The concerns are not short term.

Although the long-term outlook into the middle of the century is more difficult to predict, Macroeconomics suggests the ageing population and rising costs of health technology could push the structural deficit to above 5 per cent of GDP without significant remedial action.

This is in line with the government’s ­intergenerational report, last published in 2010, which noted the proportion of working age people is projected to fall, with only 2.7 people of working age to support each Australian aged 65 years and over by 2050, compared with today’s five-to-one ratio.

The gap between budget expenses and revenue is projected to balloon to 5 per cent of GDP in 30 years’ time, the Intergenerational Report warns.

Why does this matter? After all, debt and deficits are not necessarily bad.

The aim of successive governments has been to run budget surpluses “over the cycle", allowing the automatic stabilisers (lower tax revenue and higher welfare payments) to temporarily push the budget into deficit when there’s an economic downturn.

But for reasons already mentioned, the Australian economy is performing reason­ably well in aggregate, notwithstanding challenges for some sectors. It seems reasonable to assume we are at a point in the cycle where we should be in, or close to, surplus, rather than staring at multi-year deficits as far as the eye can see.

Warning of a credit downgrade

The budget position is now capturing the attention of credit ratings agencies. Although there is no immediate prospect of Australia losing its AAA rating, Standard & Poor’s warned this week that government must chart a credible path back to surplus in the next five years or face a downgrade.

That would not only increase the government’s borrowing costs and debt repayments, but have a knock-on effect to the country’s banks, which are implicitly backed by the government. A Commonwealth downgrade would almost certainly mean the big four banks fall out of the AA rating band, increasing their cost of funds and pushing up the price of credit.

Still, experts such as Westpac Institutional Bank chief Rob Whitfield point out that federal government borrowing costs are at historic lows, putting it in a position to borrow to fund infrastructure projects.

That is true. The issue at present is that the deficit spending is overwhelmingly financing recurrent expenditure on areas such as welfare, industry assistance, defence, health and education. Very little of the federal budget is financing productive infrastructure that could produce a long-term pay off.

The $44 billion needed to fund the national broadband network does not even hit the budget bottom line, because the NBN Co has been set up off the government’s balance sheet.

So after years of appearing to over-spend temporary windfalls, governments have refused to tighten their spending belts.

Business has tightened its belt in response to the higher dollar, but the government has not had the same conviction.

Still, business is complicit in some of the budget failings. For example, BHP Billiton chairman and former Ford president
Jac Nasser
has called for governments to further prop up the car industry with taxpayer money, while simultaneously warning Labor against taxing miners more heavily.

Another contradiction is from industry groups seeking an extension of various tax breaks, such as for research and development, while also wanting income tax and company tax cuts.

Swan has overseen some nips and tucks to various programs, including introducing a means test of $150,000 on most family payments and the baby bonus, and cuts to tax breaks on employee share schemes and superannuation for the wealthy.

But Labor has not had an overarching framework or a big hard-cutting budget.

Political economists argue the ideal time to make the hard cuts is in the first year of a new government. Labor got spooked by the GFC in its first budget in 2008 and then went hell for leather in its 2009 stimulus budget, increasing spending $44.2 billion or 12.7 per cent to ward off the GFC impacts.

Still spending up large

Regardless of the merits of the size of the stimulus, the so-called “temporary" spending was never properly unwound and has actually continued to rise in nominal terms since the stimulus package.

Hence, the spending baseline of $371 billion in 2011-12 is not sustainable without big spending cuts or large tax increases.

“You can either balance the budget by ­cutting spending or by raising taxes," Bartos says.

“I favour a mix of both, with consideration to the unfinished agenda of the Henry tax review."

If the opinion polls are accurate, the Coalition’s key treasury and finance frontbenchers,
Joe Hockey
and
Andrew Robb
, will be in for a very nasty hospital pass from Labor come September.

Given the budget rot set in during the final years of the Howard government and has deteriorated since, it seems appropriate that they will have to play their part in repairing the fiscal mess. Hockey will need to act on the entitlement mentality he has identified.